The total face amount of life insurance currently in force in the United States is approximately $20 trillion, according to the insurance research and rating firm A.M Best.
This FIGURE represents a very large proportion of the total amount of financial assets owned by U.S. households and is about the same magnitude as the total capitalization of the U.S. debt and equity markets combined and is over twice as large as the total value of residential real estate in the U.S. which is estimated at approximately $9 trillion. While life insurance is clearly an enormous asset class in the U.S., it is also the least liquid financial asset. Up until very recently, no secondary market existed for reasonably healthy insureds desiring to sell their policies and the only source of liquidity for insureds was the issuing insurer—typically, in the form of a cash surrender value or policy loan.
Very recently, a secondary market for life insurance called the life or senior settlement market has emerged. In a typical life settlement transaction, an insured sells his in force policy to a life settlement broker or similar financial intermediary. The insured transfers all rights—e.g., cash surrender value, death benefit, etc.—and all obligations—e.g., future required premium payments—to the intermediary in consideration for a lump sum payment. The amount of the lump sum payment typically reflects the present value of the rights of the policy less its obligations, adjusted for the mortality risk of the insured, the expected duration of the death benefit, the credit risk of the insurer, the nature and quality of the underlying assets, if any, determining the value of the rights and obligations, and other relevant risks. In many cases, the fair value of the insured's policy can greatly exceed the cash surrender value, thereby providing a strong incentive for the development of a secondary market. In addition, an insured may desire to sell the policy for other reasons, such as a change in factors motivating the initial life insurance purchase. For example, since the original issuance of the policy, the insured may have experienced a change in health status, estate planning goals, financial condition, tax planning goals, employment status (e.g., so called “key man” policies held by the insured's business may no longer be needed), marital and family circumstances, and similar factors relevant to purchasing and maintaining an in force policy. In addition, the insured may desire to diversify the credit risk inherent in a life insurance policy: the credit ratings of life insurers imply significant default risk and an insured may wish to eliminate this substantial exposure to the fortunes of a single life insurer.
Given the aggregate amounts of life insurance in force, a liquid secondary market for policies will require significant amounts of capital from institutional investors. Other potentially large financial markets have in the past benefited greatly from the process of securitization, wherein diverse underlying pools of obligations bearing varying risk and expected return characteristics have been reassembled, rated, and packaged into classes of securities. These securities are then purchased (or subject to repurchase or “repo” transactions which is a form of securitized lending) by institutional investors such as fixed income asset managers. Various methods exist in the financial industry to securitize such obligations as mortgage loans, credit card receivables, commercial loans, and corporate bonds. One form of securitization has been described in U.S. Pat. No. 6,088,685, creating securities from open end mutual funds so that such funds can be transacted in continuous time.
It is believed that there presently exists no means to securitize life settlement contracts. Such contracts are inherently more difficult and less amenable to securitization. It is believed that the following characteristics of life settlement contracts make their securitization much more difficult than other obligations:
1. Mortality Extension Risk: An insured may live longer than the expected time of death as indicated by an actuarial assessment of the insured, given his current health status, age, etc. This risk is of great consequence to an investor as delays in receiving cash flows derived from death benefits lowers the investor's rate of return. More problematic from the perspective of the investor, this mortality extension risk may not be entirely idiosyncratic or diversifiable in that advances in medical technology and healthcare may reduce average mortality rates for the entire portfolio of life settlement contracts. Mortality extension risk therefore poses new securitization challenges.
2. Collateral diversity: Life insurance policies vary greatly in terms of premium payment schedules, death benefits, cash surrender value, underlying lives insured, and exposure to interest rate, equity, credit and other risks. For example, term, universal, variable, whole, variable universal, and second-to-die life insurance policies all have varying rights, obligations, and risks which are illiquid, sometimes ill-defined, and invariably more difficult to disaggregate and value compared to the risks borne by, for example, mortgage loans and other assets which have heretofore been widely securitized. Since all of these types of policies can be sold via a life settlement contract, an efficient means of securitization of the underlying risks in the policies can significantly reduce the cost of funding the purchase of the underlying policies.
3. Credit Risk: Most owners of life insurance probably do not give much thought concerning their credit risk inherent in their policy. Yet, many life insurers have credit ratings which imply that the risk of default is quite high, especially when cumulated over the inherently long horizon of a life insurance policy. For example, many life insurance companies maintain an “A” rating from Standard and Poors. An “A” rated life insurance company may have to pay its bondholders up to several hundred basis points per annum above the rate required on default-free securities (e.g., U.S. Treasury securities) thereby implying a probability of default of several percent per annum. Over a period of 10 to 20 years, the premium that life insurance companies must pay to their bondholders imply significant chances of default, perhaps 30, 40 or 50% or more. Yet life insurance policyholders, unlike bondholders, are unlikely to be focused on this risk. An insured, however, may find it desirable to sell his policy to eliminate the unwanted credit exposure to the life insurance company. The credit exposure must then be valued and managed so that the underlying policies can be reconstituted as SCLSO's, the majority of which preferably can obtain a higher credit rating than the underlying insurance policies.
4. Interest Rate Risk: Many varieties of life insurance combine a standard death benefit feature with an investment in a financial product. Universal life insurance products combine a fixed income investment product with standard life insurance death benefits. Both the required premium payments and the death benefit can be variable, depending upon the rate of growth in the investment product. Typically, policyholders receive floating rate interest on their investment product and therefore tend to be “short” relative to the bond market in the sense that universal life insurance will perform less well when bond prices are rising then when they are falling. In any event, the increased contractual complexity and interest rate risk inherent in these types of policies can make securitization more difficult.
5. Equity Risk: Some types of life insurance products—such as variable life insurance—have premium obligations, death benefits, and cash surrender values which are tied to the performance of a broad array of financial products selected by the insured. Insureds typically select financial products which bear significant and systematic equity exposure, such as a mutual fund which indexes its performance to the S&P 500. These exposures entail an added dimension of securitization complexity.
6. Negative Cash Flows: An in force life insurance policy may require ongoing periodic premium payments in order to prevent the policy from lapsing. The purchaser of the policy assumes the obligations of any future premium obligations. From the perspective of the purchaser, a life settlement contract may therefore entail significant negative cash flows reflecting the ongoing premium obligations. Underlying assets with such negative cash flows have typically not been the subject of securitization efforts and pose additional challenges.
7. Mortality Covariance: The mortality risks associated with the underlying life settlement contracts may have complicated statistical structures, heretofore unknown in existing areas of securitization. For example, so-called second-to-die or joint survivor policies typically insure married couples and pay death benefits upon the death of the last surviving spouse. The mortality rates of lives insured in such policies are not statistically independent and pose further complications for efficient securitization.
8. Mark-to-Market Difficulties: Both a cause and a consequence of the lack of a liquid secondary market in life insurance is the difficulty in ascertaining the fair value of a policy at any point in time. The value of a policy is a complex function of mortality rates, insurer credit risk, interest rate and other market risk, and options embedded in the terms of the policy. The challenges in obtaining timely and accurate valuations—or mark-to-market values—for the underlying life settlement contracts have inhibited efficient means of securitization.
9. Identity Security: The owner of a life settlement contract or security derived from such contract has a direct financial interest in the mortality experience of the lives insured by the underlying insurance policies. It is therefore desirable to protect the insureds from potential criminal activity by protecting the identity of the insureds and keeping any information that could identify the insureds secure from the ultimate owners of the SCLSOs.
In addition to the above characteristics, it is believed that three additional features of life settlement contracts potentially inhibit efficient securitization:
1. Aggregated Credit Risk of Assets and Liabilities: Life settlement contracts reflect the underlying nature of the life insurance policies on which they are based. In a typical life insurance policy, the asset side of policy is the stochastically timed death benefit payable upon the death of the insured. The liability side of the policy balance sheet is the stream of ongoing premium obligations that must be satisfied to keep the asset side of the policy in force. Thus, the assets and liabilities of life insurance policies are uniquely intertwined and correlated, which is distinct from other types of financial instrument balance sheets, such as mortgage backed securities.
2. Correlation of Assets and Liabilities: Another unique feature of life settlement contracts and life insurance policies not addressed in the securitization prior art is the perfect negative correlation of the value of the assets and liabilities of the contracts and policies. The perfect correlation can be readily illustrated by considering the impact of changing longevity on the value of a life insurance policy. For shortened longevity, the value of the asset of a life insurance policy—the death benefit—is increased since the death benefit is payable earlier and therefore has a larger present value. In addition, however, the obligations to pay future premiums in the event of shortened longevity are completely extinguished, so the present value of liabilities can be substantially lower in this scenario. Thus, for shortened longevity, the present value of life insurance policy assets is increased at the very same time that the present value of life insurance policy liabilities is decreased. If the sign of the liabilities is generally negative, the liabilities in the shortened longevity scenario are less negative. With this sign convention, the correlation between the asset and liability value is equal to one, i.e., perfect positive correlation. Likewise, for longer than expected longevity, the correlation between the value of the death benefit asset and the premium liability stream can also be seen to be perfectly positive. As the insured lives beyond his expected lifespan, the present value of the death benefit is lowered. At the same time, the liabilities become more negative, again reflecting the perfect positive correlation between the death benefit assets and the premium liabilities.
3. Taxation Efficiency: Conventionally, life insurance has been favored under the U.S. tax code in a number of ways. First, life insurance death benefit proceeds are generally excludable from gross income under section 101(a) of the tax code (U.S. Title 26). Additionally, the investment income received from invested premiums inside the policy (so called “inside buildup”) is also either tax free or tax deferred. Given the tax favored status of life insurance, the tax code recognizes that taxpayers receive a substantial benefit. The nature of these benefits means that it is generally the case that premium payments and interest paid on debt to finance premiums payments for life insurance are not deductible. However, the status of a life insurance policy changes materially when it is the subject of a life settlement transaction. Once a policy has transferred for valuable consideration, the death benefit is generally no longer excludable from gross income. However, some of the same provisions which prevent deductibility of premiums and interest on premium financing may still apply.